Literature Review – Credit Derivatives

Review of Literature on Credit Derivatives

Giesecke, K. (2009) says that a credit derivative is a financial instrument whose cash flows are linked to the financial losses due to default in a pool of reference credit securities such as loans, mortgages, bonds issued by corporations or governments, or even other credit derivatives. Credit derivatives facilitate the trading of credit risk, and therefore the allocation of risk among market participants. They resemble bilateral insurance contracts, with one party buying protection against default losses, and the other party selling that protection. He discusses the mechanics of standard contracts, describes their applications, and highlights the mathematical challenges associated with their analysis.

Dufey & Rehm(2000) say that credit derivatives are contracts between two financial market participants.The essence of this contract is to transfer credit risk from one party to another.Like all financial innovation, a credit derivative is a new financial product which is developed by unbundling various components from a traditional financial contract & “repackaging” them into a new contract. Features of this contract are underlying,strike price,credit event, maturity, protection payment&settlement. Credit derivatives are mainly used for management of credit lines.Credit derivatives enable banks to originate loans according to their client relationships, they remove credit risk from balance sheets while retaining ownership over the loans.

Ashraf, Altunbus & Goddard (2005) say that credit derivatives have been as revolutionary financial innovation allowing credit risk to be transferred to third party without the ownership of underlying asset. Credit derivatives take a number of forms, they can be pure such as credit default swaps or synthetic such as credit linked notes. Banks are major players in credit derivatives business, they buy & sell protection. Credit derivatives are welcomed by regulators due to their ability to transfer the most illiquid asset namely loans on a bank’s balance sheet. Motivation behind using credit derivatives may be the capital arbitrage & need to meet minimum regulatory capital requirements. However, this factor cannot be used to determine volume of credit derivatives transacted.

Stulz, Williamson, Minton (2006) examine the use of credit derivatives by US bank holding companies from 1999 to 2003 with assets in excess of one billion dollars. Using the statistics from Bank for International Settlements they show that the notional amount of credit derivatives increased from $698 billion at the end of June 2001 to $4664 by the end of June 2004.Increase in bank size is positively & significantly related to the likelihood of hedging with credit derivatives. They studied whether the likelihood of hedging with credit derivatives is related to the type of loan a bank makes. They also studied why there is limited use of credit derivatives by banks. They found out factors like transaction costs, capital convertibility & moral hazard issues are related to their limited use.

Gibson, M. (2007) discussed the risk management challenges posed by credit derivatives. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Credit rating agencies interpret this complexity for investors, but their ratings can be misunderstood, creating rating agency risk. The settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, market participants must meet these risk management challenges. He also discussed how various types of credit derivatives are used by three types of market participants namely commercial banks, investment banks and investors.

Partnoy & Skeel (2007) survey the benefits and risks of credit derivatives and also look at how the use of these instruments affects the role of banks and other creditors in corporate governance. The benefits include increased opportunities for hedging, increased liquidity, reduced transaction costs, and a deeper and potentially more efficient market for trading credit risk. The risks are moral hazard and other incentive problems, limited disclosure, potential systemic risk, high transaction costs and the mispricing of credit. They also suggest reforms that might resolve some of the costs and risks associated with credit derivatives. The three primary areas of reforms are disclosure, credit ratings and non-debtor termination rights in bankruptcy. They think that the future of credit derivatives lies in the innovative use of these new contracts by the parties themselves.

Usman Ali, P. (2001) discusses the new applications of credit derivatives. Credit derivatives can be used to hedge currency convertibility risk, hedge dynamic credit risk, create leveraged positions, enhance investment returns, exploit credit arbitrage opportunities and create synthetic assets. He argues that the most common form of credit derivative continues to be the “vanilla” credit default swap, but the market has now shifted decisively towards more “exotic” credit-linked notes.

Dickinson, E. (2008) explores how credit default swaps (CDSs) could hypothetically create systemic risk, how CDSs have caused the current financial crisis, and how the U.S. legislature could best regulate CDS to minimize systemic risk in the future. In theory, CDS could foster systemic crisis by means of encouraging the growth of dangerous asset bubbles, and causing the collapse or failure of an institution that is systemically significant. This paper questions whether CDS helped support the growth of the sub-prime mortgaged-backed securities asset bubble that has been blamed for igniting the current financial crisis. Ultimately, there is evidence cutting both ways, thereby encouraging further research into the issue. This paper recommends that legislators require CDS market participants to maintain increased capital reserve requirements when involved in the purchase or sale of CDS tied to highly speculative debt, and confidentially disclose their CDS positions to the Federal Reserve. Increasing the capital reserve requirements for companies that trade in junk-grade CDS is essential for two reasons. First, higher capital reserve requirements protect the solvency of systemically significant institutions that attempt to profit from the riskiest CDS. Second, specifically targeting CDS that are associated with the junk lending business will discourage banks from extending cheap credit to unworthy borrowers, thereby reducing the potential for markets to generate precarious asset bubbles. As a second regulatory measure, confidential disclosure of CDS positions to the Federal Reserve is an efficient but relatively non-intrusive way to greatly facilitate the monitoring of systemic risk going forward.

Fabozzi, Goodman and Lucas (2007) discuss collateralised debt obligations (CDOs). They begin with the basics of CDOs and then discuss synthetic CDOs. A CDO issues debt and equity and uses the money it raises to invest in a portfolio of financial assets, such as corporate debt obligations or structured debt obligations. It distributes the cash flows from its asset portfolio to the holders of its various liabilities in ways that take into account the relative seniority of those liabilities. Any CDO can be well described by focusing on its four important attributes: assets, liabilities, purposes, and credit structures. CDOs are created for one of the three purposes namely balance sheet, arbitrage and origination. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed. As with any new complex financial product introduced by banks, there are regulatory and supervisory concerns. The introduction of new Credit Risk Transfer (CRT) vehicles, such as cash CDOs and credit derivatives that are employed to create synthetic CDOs, has elicited the same cautious response from overseers of the global banking system. They discussed the four main concerns associated with Credit Risk Transfer namely, clean risk transfer, risk of failure of market participants to understand associated risk, potentially high concentration of risk and adverse selection.

Choudhry, M. (2002) provides a description of the main types of credit derivatives and how they may be used by fixed income portfolio managers. He also deals with the risks in credit default swaps, and how this highlights the need for more awareness on legal definitions. Credit derivatives allow investors to manage the credit risk exposure of their portfolios or asset holdings, essentially by providing insurance against deterioration in credit quality of the borrowing entity. Credit derivatives can be an important instrument for bond portfolio managers as well as commercial banks, who wish to increase the liquidity of their portfolios, gain from the relative value arising from credit pricing anomalies, and enhance portfolio returns. He also explains main types of credit derivatives namely credit default swap, credit options, credit linked note, and total return swaps. The most common credit derivative is the credit default swap, credit swap or default swap. Credit options are also bilateral OTC financial contracts. A credit option is a contract designed to meet specific hedging or speculative requirements of an entity, which may purchase or sell the option to meet its objectives. A standard credit-linked note is a security, usually issued by an investment-graded entity that has an interest payment and fixed maturity structure similar to a vanilla bond. A total return swap (TRS), sometimes known as a total rate of return swap, is an agreement between two parties that exchanges the total return from a financial asset between them. This is designed to transfer the credit risk from one party to the other. It is one of the principal instruments used by banks and other financial instruments to manage their credit risk exposure, and as such is a credit derivative. He also explains why portfolio managers use credit derivatives. Credit derivatives are used to enhance portfolio returns, reduce credit exposure, gain exposure to those market sectors for which cash exposure is not desirable, and trade credit spreads. He also deals with the risks in credit default swaps namely loan maturity and comparison of synthetic and cash positions.

Brandon and Fernandez (2005) give an introduction to credit derivatives. Credit derivatives are financial products that isolate credit risk, have payoffs that are contingent on the occurrence of a credit event, such as failure to pay, obligation acceleration, restructuring, moratorium and repudiation; and, reflect the market’s assessment of the likelihood of the reference asset experiencing a credit event within certain time frame and the expected value of the reference asset after the event.

Bomfim (2001) provides a brief overview of the credit derivatives market. He also discusses the uses of credit derivatives, main market participants and also the types of credit derivatives. He says in his work that credit derivatives market is still young even after tremendous growth in the past few years.He also tries to explore the future of credit derivatives market and the factors that can affect its development.

Mahieu and Xu (2007) studied the use of interest rate and credit derivatives by banks for trading and for hedging and they found that the value of derivatives held for hedging is much smaller when compared with the value of derivatives used for trading. The paper empirically investigates two questions. Firstly, what makes a bank hedge in certain periods and not others? For this they studied U.S. bank holding companies (BHCs) that have used interest rate or credit derivatives during the period 1997 to 2005. They found that banks are more likely to be hedgers with interest rate derivatives when loan commitment, demand deposit, ROE, size and credit spread are higher; higher interest rate and term spread reduce the likelihood of a BHC being a hedger with interest rate derivatives. Higher transaction deposit, larger size and the engagement in the trading of credit derivatives induce banks to become hedgers with credit derivatives. Secondly, they investigated how the change in a bank’s derivatives holding can be explained? They found that credit derivatives are more likely to be used for hedging when a bank engages in securitization and in trading of credit derivatives.

Lokken (2009) addresses the U.S. taxation of credit default swaps and primarily deals with the explanation of credit default swaps and their use in investment and financial transactions. He compares credit default swaps with insurance. Although credit default swaps resemble insurance, they are not regulated as insurance, a fact that has considerable importance to the swap market. Insurance laws generally require the insured to have an insurable interest and allow an insured to recover no more than indemnity for a established loss. A protection buyer under a credit default swap is not required to have an insurable interest and may be a speculator. This paper examines several sets of U.S. tax rules that could apply to credit default swaps. Under current law and current market conditions, two alternatives namely treating credit default swap as contingent put options and treating these swaps as notional principal contracts are feasible.

Bilgin (2005) provides a comprehensive commentary on the state of the credit derivatives market, especially emerging markets, today and a basic understanding of credit risk, credit derivatives and the usage of credit derivatives, by surveying the academic and the practitioner literature on credit derivatives. He mainly studies single name and multi name credit derivatives.  He also examines key products in emerging markets and found credit default swaps, credit linked notes, synthetic collateralized debt obligation and first to default basket products are the products used in emerging markets and found that hedge funds, mutual funds and banks are the key players. He also stresses on the pros and cons of credit derivatives. Some of the pros of credit derivatives are that they help trade default risk, have large range of maturity, there is no collateral constraint etc. Cons of credit derivatives are that there is absence of secondary market, total return swaps are subject to market risk, documentation is complex and lengthy and also the interpretation of credit event clauses can be difficult.

Mengle, D. (2007) describes credit default swaps, total return swaps, and asset swaps, but focuses mainly on the transaction mechanics, features and risks of credit default swaps. The paper then describes the market for credit default swaps and how it evolved, followed by an overview of pricing, valuation and the risk management role of the dealer. Next, the paper considers the costs and benefits of credit derivatives and describes some recent policy issues. The paper concludes with a consideration of the possible future direction of the market.

Kiff, Elliott, Kazarian, Scarlata and Spackman (2009) address two basic questions. First, do credit derivative markets increase systemic risk? Second, should they be regulated more closely, and if so, how and to what extent? The paper begins with a basic description of credit derivative markets followed by an assessment of systemic risk. They argue that counterparty risk remains a major risk in all CDS transactions. They say that some systemic risks could be removed if policymakers had access to more detailed information about the transactions. Better information would enable authorities to detect market abuse.

Henderson (2009) explores whether credit derivatives should be regulated as insurance and suggests an alternative form of regulation for these financial instruments. The paper also explores the probability that the credit derivatives market should be regulated as insurance. It shows that the argument that some credit derivatives help banks and other providers of debt share risk with other investors is not sufficient for credit derivative contracts in general to be deemed “insurance.” It concludes by stating that insurance regulation is not apt for the credit derivatives market, while conceding that some sort of regulation may be necessary. The paper is divided into four sections. First section gives an overview of basic credit derivatives. Second deals with the argument for regulating credit derivative as insurance. Third section states that credit derivatives are within insurance law. Fourth section suggests that an exchange platform for credit derivatives could solve some of the problems associated with credit derivatives.

Kumar, A. (2007) studies the development of credit derivatives market and the implications of it from a macro economic perspective on monetary policy and financial system and its stability. He also discusses implications of credit derivatives for India. Credit derivatives will help banks in India to transfer credit risk and hence free up capital resources. He also argues that in order to have an efficient market for credit default swaps it is important that there are large numbers of market makers. To achieve this insurance companies and mutual funds should be allowed to enter this market. He says that credit derivatives will help improve financial stability by facilitating dispersion of credit risks but concerns are because it is argued that credit derivatives spread the risks so wide that it is impossible to track them. He concludes by saying that in emerging markets like India institutional concerns like clearing and settlement agencies can impede the growth of credit derivatives market.

Prato, O. (2002) discusses the uses of credit derivatives. Credit derivatives can be used as hedging instruments, investment and trading instruments. Credit derivatives can broadly be divided into two categories namely funded and unfunded instruments. Funded instruments are credit default swaps, credit spread options, total rate of return swaps and first to default swaps. Unfunded instruments are credit linked notes. He then discusses risks associated with credit derivatives. In addition to interest rate and exchange risk, there is also specific risk of reference entity. Credit derivatives are also subject to operational risks. These can be divided into two categories namely legal risks and due diligence rules related to monitoring of credit derivatives trading. He argues that internal risk management systems must be strengthened further so as to prevent any catastrophes from happening to name a few, Enron and the case of Argentina default.

Rule (2001) discusses the credit derivatives market. Main market players in the credit derivatives market are commercial banks, insurance companies, hedge funds, non financial companies and intermediaries. He also raises some important questions about the credit derivatives market such as will credit default swaps work for protection buyers when needed? To what extent might the information asymmetry limit the development of the market? What will be the impact of credit derivatives on corporate debt restructuring? He also says that the development of these markets has clear potential benefits for financial stability because they allow the origination and funding of credit to be separated from the efficient allocation of the credit risk. Growth of credit derivatives markets has led to increase in off balance sheet transactions among international banks, securities firms and insurance companies.

Kane (2001) explains the mechanics, risks and uses of the different types of credit derivatives.  He also discusses various bank capital treatments for credit derivatives in light of the new Basel capital accord The primary purpose of credit derivatives is to enable efficient transfer and repackaging of credit risk. Credit derivatives documentation has been simplified by ISDA. Banks continue to dominate the credit derivatives market. Banks use credit derivatives to reduce regulatory capital, for banks credit derivatives provide an unfunded way to diversify revenue and hence the regulatory treatment of banks has a major impact on credit derivatives. Insurance and re-insurance companies also have become major players in this market. He states the applications of default swaps as hedging, investing and trading. He also explains different types of CDOs namely cash flow, arbitrage and synthetic.

Kim (2008) says that the credit derivatives are like a new continent with boundless opportunity and raises questions like are credit derivatives transaction a financial transaction or a gambling? This paper explores interpretation of the term “credit event” which is an important element of settlement in the credit derivatives transaction. The paper is divided into four parts. First part introduces similar derivatives that were historically used by financial institutions and mentions the development process of the derivative financial market. Second part provides a brief explanation of the various financial products that are used in the credit derivatives market. Third part addresses the legal mechanism of a credit derivatives swap, the most frequent type of transaction in the market today. Fourth part discusses general issues related to the credit event.